Arbitrage is a financial strategy that involves the simultaneous buying and selling of related assets or financial instruments to exploit a price discrepancy for profit. Arbitrage opportunities exist due to inefficiencies in markets or pricing disparities between related instruments. Typically, arbitrage is considered risk-free, as it seeks to capitalize on price differences across markets or similar instruments without exposure to the underlying asset's risk.
Types of Arbitrage
- Spatial Arbitrage: This involves buying and selling the same asset in different markets to take advantage of differing prices for the same asset.
- Temporal Arbitrage: Here, the arbitrageur exploits price differences between the same asset at different points in time.
- Risk Arbitrage: This type of arbitrage involves capitalizing on price discrepancies between related securities; for example, buying and selling shares in companies that are involved in a merger or acquisition.
- Statistical Arbitrage: Statistical models and quantitative techniques are used to identify short-term trading opportunities.
- Covered and Uncovered Arbitrage: Covered arbitrage involves a risk-free profit, while uncovered (or "naked") arbitrage involves some risk.
- Identification: The first step is identifying the arbitrage opportunity.
- Execution: Simultaneous buying and selling of the identified assets.
- Closure: The positions are closed once the price discrepancy is eliminated or reduced to a level where arbitrage is no longer profitable.
- Execution Risk: Delays in trading can negate the arbitrage opportunity.
- Price Change Risk: Asset prices may change before both sides of the trade are complete.
- Liquidity Risk: Lack of sufficient liquidity can affect the ability to execute trades.
- Model Risk: Inaccuracies in valuation models can result in false arbitrage signals.
- Price Correction: Arbitrage helps in bringing prices to their “correct” levels.
- Increased Efficiency: It makes markets more efficient by reducing price discrepancies.
- Liquidity: Arbitrage can add liquidity to markets.
Arbitrage in Different Markets
- Financial Markets: Stock, bonds, commodities, etc.
- Foreign Exchange Markets: Arbitrage between currency pairs.
- Cryptocurrency Markets: Price differences across various crypto exchanges.
- Retail and Online Markets: Buying low from one retailer and selling high on another platform.
Limitations and Criticisms
- Barriers to Entry: High costs and technological requirements can prevent retail investors from participating.
- Short-lived Opportunities: Arbitrage opportunities are often quickly corrected.
- Regulatory Risks: Some forms of arbitrage may border on market manipulation, subjecting the arbitrageur to legal risks.